Key Takeaways:
1. China’s Carbon Market Expands in 2024: The emissions trading scheme (ETS) will broaden to include steel, aluminium, and cement sectors, eventually covering up to 75% of the country’s emissions as more industries, like oil refining and aviation, are added.
2. Driving Industry Change Through Efficiency: The ETS focuses on reducing emissions intensity (emissions per unit of output), which could force smaller, less efficient steel producers out of the market, encouraging the use of cleaner technologies like electric arc furnaces (EAFs).
3. Opportunities to Strengthen the Market: Challenges remain, such as oversupply of allowances and data verification issues, but future reforms like auctioning emission allowances and setting a total emissions cap after 2030 could drive deeper carbon reductions and help China meet its climate goals.
China’s national emissions trading scheme (ETS) is set to enhance its significance as the world’s largest carbon market. Earlier this month, the Ministry of Ecology and Environment (MEE) announced a draft policy indicating that, by the end of 2023, the ETS will extend beyond the power sector to include the steel, aluminium, and cement industries. From 2024 to 2026, companies in these new sectors will receive free allowances for their carbon dioxide (CO2) emissions, with no cap on the total number of allowances available. These allowances represent the amount of emissions that the government permits companies to emit. Starting in 2027, however, the government plans to tighten the issuance of these allowances.
Potential for Impact
The expansion of the ETS could significantly enhance China’s carbon reduction efforts. However, analysts, including experts from Carbon Brief, caution that the scheme’s emphasis on emissions intensity—measured as emissions per unit of output—rather than on total emissions, may limit its overall effectiveness.
Urgency of Emission Reductions
Yan Gang, vice-dean of the MEE’s China Academy of Environmental Planning, explained to the state-supporting newspaper Economy Daily that the inclusion of steel, aluminium, and cement in the ETS is partly due to the urgent need to reduce emissions from these sectors. However, unlike many other global carbon markets, China’s ETS is structured around carbon intensity. This focus could hinder its ability to drive substantial changes in production practices and reduce overall emissions.
Lauri Myllyvirta, a senior fellow at the Asia Society Policy Institute’s China Climate Hub, identified this focus on emissions intensity as the “fundamental” issue limiting the scheme’s capacity to penalize high carbon emitters effectively.
With the new plan, the share of national CO2 emissions encompassed by the carbon market will increase from 40% to 60% of China’s total emissions, according to the MEE. This shift represents a significant step toward a more comprehensive approach to emissions management in the country, albeit with challenges that remain to be addressed in future policy adjustments.
Low Prices, Oversupply, and Data Verification
Myllyvirta has raised concerns on social media about how China’s emissions trading scheme (ETS) impacts carbon-intensive industries. He points out that these industries are facing a relatively low carbon price, a mere fraction of the price of emission allowances. Myllyvirta notes that some enterprises may even profit by increasing production if their emissions intensity falls below the industry benchmark—a government-set standard for acceptable emissions.
Even if the system were to shift to a total emissions cap—setting an absolute limit on the CO2 companies can emit—Myllyvirta emphasizes that this would only be effective if the cap is stringent enough to drive up carbon prices and thereby reduce emissions. He adds that many companies, particularly in sectors like steel, aluminium, and cement, have already made substantial gains in efficiency, reducing their emissions intensity. As a result, there are few remaining “low-hanging fruit” to pick in terms of easy emissions cuts.
“You can’t ratchet the benchmarks low enough to create strong incentives and drive up carbon prices,” Myllyvirta explains.
Uncertainty in the Market Expansion’s Impact
The expansion of the ETS to new sectors in 2024 introduces uncertainty. Chen Zhibin, senior manager for carbon markets and pricing at the consultancy Adelphi, explains that without detailed allocation plans, it is difficult to assess how the expansion will impact industries. Chen notes that he does not anticipate “high pressure” on these industries to reduce emissions immediately, given that many companies will continue to receive generous allowances, as seen in previous years.
Oversupply remains a persistent issue in China’s carbon market. A 2021 report by think tank TransitionZero revealed that power companies, on average, received 17% more allowances than they required for the 2019-2020 compliance cycle. This oversupply depresses carbon prices and weakens the incentive for companies to trade allowances and reduce emissions. Xu Nan, a member of the All-China Environmental Federation’s Green Inclusivity Committee, warns that issuing more free allowances in the expanded ETS could exacerbate this problem, further suppressing prices and reducing market efficiency.
Data Verification Challenges
Accurate data collection and verification have been significant challenges in China’s ETS since its inception. The original launch of the scheme was delayed due to difficulties in collecting reliable emissions data. In 2022, the Ministry of Ecology and Environment (MEE) reported instances of “negligence and fraud” in the emissions data from thermal power plants, including falsified figures and improper coal sampling.
To address these issues, China introduced stricter regulations in February 2024 aimed at curbing data fraud. The government also outlined a goal to establish a comprehensive system for measuring CO2 emissions by 2025. Chen Zhibin explains that data verification requirements have been significantly tightened compared to two years ago. The MEE has invested substantial resources into this effort, including dispatching personnel to various provinces to ensure the accuracy of reported emissions data.
The latest draft policy for the ETS adds a three-tiered review mechanism involving national, provincial, and municipal levels, which aims to improve the reliability of emissions data verification. This new framework is expected to strengthen China’s ability to ensure the accuracy of emissions reporting as the ETS expands to cover more sectors.
Managing Steel Output in China’s Carbon Market
Lauri Myllyvirta believes that incorporating steel production into China’s emissions trading scheme (ETS) presents an opportunity to enhance the benchmarking system, particularly with the increasing adoption of electric arc furnaces (EAFs). This steelmaking method significantly reduces carbon emissions compared to traditional methods. By establishing a uniform benchmark for both EAFs and blast furnace-basic oxygen furnaces (BF-BOFs), Myllyvirta argues that this could lead to greater utilization of EAFs, supporting China’s targets for EAF steel production.
However, he cautions that if the current design for power plants, which assigns different benchmarks to various plant types, is any indication, achieving this uniformity is unlikely.
Industry Consolidation and Emissions Reduction
Luyue Tan, a senior carbon analyst at the London Stock Exchange Group, and Chen Zhibin contend that the ETS’s focus on emissions intensity might be a strategic effort to push less efficient and smaller manufacturers out of the crowded steel market. This consolidation could lead to a reduction in the number of steel producers, thereby lowering overall emissions in the industry.
Tan further notes that this consolidation would decrease the supply of allowances in the carbon market, enhancing its appeal to participants and potentially driving up prices.
The Role of the ETS in China’s Climate Policy
Currently, Chen emphasizes that the ETS is just one tool among many in China’s climate policy arsenal, with other elements—such as rapid renewable energy installations—playing a more significant role. However, Zou Ji, CEO and President of the Energy Foundation China, has stated that the ETS is crucial for making China’s energy transition more cost-effective.
A report released by the International Energy Agency (IEA) in May 2024 underscored the potential advantages of strengthening China’s ETS, particularly through the introduction of allowance auctions instead of granting them for free. The report states:
“Strengthening the national emissions trading system can send a robust price signal for decarbonization, drive cost-effective emissions reductions, and guide low-carbon investments—all of which can help accelerate the clean energy transition and China’s progress towards its climate ambitions.”
The IEA noted that while China currently allocates all ETS allowances for free, it has expressed intentions to explore auctioning emission allowances. Implementing partial allowance auctioning could enhance the ETS’s environmental and cost-effectiveness, supporting China’s “dual carbon” goal and potentially doubling carbon savings in the power sector by 2035.
Future Expansion and Emissions Cap
Looking ahead, various industries—including oil refining, chemicals, paper, aviation, and non-ferrous metals—are expected to be integrated into the ETS, potentially increasing its coverage to 75% of total emissions.
In the long term, establishing a total emissions cap for market participants is considered essential. According to China’s recent “dual-control of carbon” policy, the focus of the country’s climate strategy is set to shift from carbon intensity to total emissions following the fifteenth five-year plan (2026-2030). Myllyvirta anticipates that the ETS will transition to a total emissions cap after 2030 once China confirms that its emissions have peaked.
Chen agrees with this timeline, noting that the draft policy does not indicate that a cap will be established sooner. He attributes part of this delay to the limited influence of the Ministry of Ecology and Environment (MEE) over economic policy compared to other agencies, such as the National Development and Reform Commission, which is China’s top economic planner.
International Pressures and CBAM
At the same time, Tan points out that there is growing “top-down” pressure to expand the ETS’s coverage to additional sectors, driven by the European Union’s carbon border adjustment mechanism (CBAM) and calls for China to adopt more ambitious international climate commitments.
Elements in the draft policy, such as the emphasis on direct emissions and the conclusion of the first phase in 2026, are closely linked to CBAM, which is set to take effect in the same year. Industries covered by the ETS may be able to avoid CBAM charges when exporting to Europe, as Xu Nan has noted. This scenario could turn the ETS into an advantage for these companies, facilitating exports rather than posing an additional burden.